As we head into RBI?s third quarter review of the 2011-12 monetary policy, the question foremost on our minds is the seeming reluctance to reverse the policy stance right away. In particular, given the persisting deficit system liquidity, why not cut CRR by 50-odd points and infuse liquidity through a more stable process than open market operations (OMOs)? How should we read RBI?s thinking on this?

We had argued about our view on reducing policy rates at the November mid-quarter policy review. The nature of the economy seems to have changed in the interregnum.

The global environment seems, even if temporarily, to have improved, although all 2012 economic forecasts have been downgraded. Global growth, despite a perceived recovery from the depths plumbed in the dismal last quarter of 2011, is far from stable and robust. There is always a risk that growth firms up sooner than later, but current indications are that there are sufficient structural weaknesses that will prevent this.

The immediate fallout is on commodity prices. The World Bank, a couple of days ago, projected significant weakness for crude and metals, in dollar terms, continuing well past 2012 into 2013. Crude, in particular, is projected to be helped by increasing supplies from Iraq and Libya.

This has implications for India?s inflation. Global conditions and a slightly higher than currently anticipated growth still do not seem to indicate that FY13 average WPI inflation is likely to cross 6%, within striking distance of RBI?s medium-term inflation target of 5-5.5%. Having said this, India is structurally oriented towards higher inflation, so a bit of upside on this estimate may be warranted.

India?s own growth, in the meantime, seems to have rejuvenated just a little bit. December PMI numbers are strongly positive, driven by large manufacturing orders. The latest IIP consumption data is showing a strong bounce back. Most of these growth rates, of course, get clouded by base effects; shorn of these, economic activity does seem to be quite muted. November?s strong IIP showing was helped by a 14.8% increase in consumer non-durables (FMCG). And this is where the fun starts. A large part of this was due to a 71% increase in newspapers in circulation, (an extra 77 lakh copies), 3% of 2010 readership of top 15 newspapers.

A pertinent question now is whether the slowdown is cyclical (i.e. driven by interest rates) or structural (policy determined). How much would RBI?s rate cuts help to stimulate investment given expectations that the policy logjam might persist? Although difficult to disentangle, one way is to use the economist?s construct on the ?real interest rate?. Real

1-year commercial paper rates (a proxy for companies? cost of funds) have been relatively low in 2011, compared to historical levels, so economic activity has been probably driven more by policy-related issues (the higher the real interest rate, the more the disincentive to invest). However, these rates are likely to rise sharply in 2012, as inflation falls, so the argument to cut rates strengthens.

So if there is a need to ease policy, should a rate cut or a liquidity instrument (like the CRR) be preferred? Although we have been projecting a tightening of liquidity for some months, the current deficit is much higher than expected levels. So, the question is: is this deficit likely to persist, or turn out to be more transient? The current shortage is likely due to a combination of factors, including the higher requirement of cash reserves that banks have to place with RBI, increasing cash with people (probably a consequence of the forthcoming elections) and, till some time back, an outflow of foreign currency funds. Is this squeeze likely to easy? On balance, probably from the current R1.5 trillion deficit levels down to around R1 trillion. Even this is much higher than the declared comfort level of +/-1% of system deposits, which is around R60,000 crore.

Are OMOs good enough to counter this deficit? Probably, when combined with LAF, since banks hold close to 30% of their assets as government securities, 6% more than the minimum required?24%?and there should be enough collateral to access these liquidity lines. At the same time, the fact that call rates (the target rate) are now almost a full percentage point above the repo rate is inconsistent with the policy stance, indicating an uneven distribution of the collateral amongst banks.

How much can RBI increase its balance sheet through additional purchases of SLR paper? The limit is only through the consequent increase in the monetary base, which a monetarist view will deem adverse for inflation. The RBI projection of M3 growth in FY12, consistent with its monetary policy stance, was 15.5%, almost the same rate as at end-December 2011. A permanent infusion of R30,000 crore through a 50 bps cut in CRR, amplified through the money multiplier, is likely to result roughly in a 17% M3 growth by end-March, probably too high for comfort.

There is also a structural component to the tight liquidity. Whether as part of design or otherwise, base money (printing money) has increased by R43,000 crore, a niggardly amount compared to the R7 lakh crore that broad money (M3) increased in April-December 2011, and the R83,000 crore in the same period of the previous year. There?s just too much demand for money chasing static printing money! The story of a sharp drop in the increase in transactional demand for money, the M1 measure, we?ll keep for another day.

A crucial consideration in monetary policy calculus is the current external environment, but this is too complex an issue to be clubbed in this general overview, and needs to be dealt with separately. Suffice it to say that the rupee?s unexpected turnaround gives RBI some leeway for easing, but the underlying conditions still warrant caution.

The net outcome of all this? While we think the net situation warrants an easing of policy, we will probably see a continuation of the pause, with somewhat lower growth being considered an acceptable tradeoff for keeping inflation expectations low.

The author is senior vice-president, business & economic research, Axis Bank. These are his personal views